Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I recently visited Vanguard where I sat down with Colleen Jaconetti, a senior investment analyst in the firm's Investment Strategy Group. We discussed some of the key swing factors involved in setting your portfolio withdrawal rate during retirement.

Colleen, thank you so much for being here.

Colleen Jaconetti: Sure, it's a pleasure.

Benz: You have done a lot of work on spending rules, whether it's the 4% rule or some other strategy, and so I'd like to drill into your research a little bit. Retirees have heard about the 4% rule. Let's discuss the assumptions that underpin that rule. What's the asset allocation of the portfolio that can supposedly support a 4% distribution rate per year? What kind of time horizon are we looking at? And also what sort of success rate is presupposed in the 4% rule?

Jaconetti: In the original 4% rule it was actually probably a moderate asset allocation, somewhere between 40% in stocks and 60% in stocks over a 30-year time horizon, and it basically claimed that people will have a high likelihood of not running out of money. So, they didn't put an exact success rate on it, I would say, but just that there will be a high likelihood investors would not run out of money before their 30-year horizon.

Benz: I know that investors often want to tweak some of those variables, so perhaps they can take more of their portfolios. Let's cycle through those variables. Time horizon, I know, is one where investors say, "Well, if I can shorten my time horizon perhaps by working longer, does that mean I can take more from my portfolio later on?"

Jaconetti: Yes, that's actually a good question. The amount of time that you are taking withdrawals from the portfolio is actually probably the most impactful about how much you could spend from the portfolio. If you were to decrease your time horizon by five years or even 10 years, you would definitely increase the amount you could spend by even 1% or 2%.

Benz: I guess the problem is, though, once you've started those distributions your time horizon at the end is really unknowable, so it's kind of tricky from that standpoint.

Jaconetti: Absolutely. But I think it's important to note that a lot of people don't realize if you started at 70 or 75 years old and your time horizon is actually maybe 15 to 20 years, even a 10-year horizon actually could be spending upward of 9% of the portfolio. I think that's a really important thing that people don't realize, that going from 4% to 9% is a lot bigger jump than maybe, say, changing their asset allocation.

Benz: Success rate is another variable that investors can look at. The Bill Bengen research, I don't know if it assumed a 100% success rate, a 100% chance of not running out of money during the retiree's lifetime. What about investors who say, "Well, I'm comfortable with a little more variability, or perhaps, I'm comfortable with the risk that I will in fact run out of money." How does that affect the overall withdrawal rate?

Jaconetti: That's probably the second most impactful lever. What happens is, we normally assume, say, an 85% success rate. So, in 85% of the scenarios the investor would not run out of money from the planning horizon. But if you would drop down to, say, a 75% success rate, a one-in-four chance [the investor runs out of money], the 3.8% initial spending rate would actually jump up to 4.4%. So, you could actually increase the amount that you can spend from the portfolio, knowing on the other end you're also increasing the amount of likelihood that you will run out of money prior to your planning horizon.

Benz: So, if you were to say, "I'm comfortable with that possibility that I will run out of money," you could potentially support a slightly higher withdrawal rate?

Benz: Now, asset allocation is another variable in this mix. You said that the Bengen research presupposed something like a blended portfolio, maybe [50% in stocks and 50% in bonds] or 40/60. How about investors who say, "Well, maybe if I nudge out my equity allocation a little bit, does that mean I can take more than 4%?"

Jaconetti: It's actually surprising that the asset-allocation decision, especially going from, say, a moderate portfolio to aggressive actually does not drastically increase the amount that you can spend from the portfolio, but it would drastically increase the volatility and risk of loss in a portfolio. So, investors should definitely be careful about trying to reach for additional spending by having a more aggressive asset allocation.

Benz: You gave me an example earlier, Colleen, where you looked at even if we take the equity allocation all the way to 80% of the portfolio, and just 20% bonds, you really cannot take an appreciably higher distribution. What sort of distribution would you be looking at even if you're comfortable with that type of equity risk?

Jaconetti: We actually only go up to 4%. So you would only go from 3.8% to 4.0%, so say, $38,000 on $1 million versus $40,000 on $1 million, for a 30% jump in equity. So, a pretty substantial jump in equity would not even give you that much of an increase in the spending amount.

Benz: You have done a lot of work, Colleen, on the nitty-gritty of taking money out of a portfolio and also figuring out if you have multiple pools of assets, maybe taxable accounts as well as traditional IRAs and 401(k)s and then Roth accounts. You have outlined some distribution rules that tend to make the most sense from a tax-efficiency standpoint.

Let's talk about that. You say that investors who are past age 70 1/2 should absolutely start with required minimum distributions before taking distributions from anything else?

Jaconetti: Right. We call this creating a paycheck for life. So in helping our clients create paycheck for life, we would definitely start with required minimum distributions since all investors over 70 1/2 have to take them by law. So we would have that money flow into a money market or checking account which we would establish upfront.

After we make RMDs there, we would also spend from the portfolio from the taxable flows. So any interest, dividends, or capital gains on assets held in taxable accounts will be the next monies that we would spend from.

Benz: So they are not getting reinvested; they're spilling over into this cash pool?

Jaconetti: Exactly. Because whether you spend them or reinvest them, you have to pay taxes on them. So if you reinvest them today and say, I have to use them to meet spending needs in three or six months, you could actually be incurring higher taxes.

Then, a lot of people surprisingly when they get to this point are like, "Gee, I can actually meet my spending needs with this amount of money."

Benz: With those two: the RMDs plus the distributions from the taxable accounts?

Jaconetti: Yes. But for those investors who maybe need a little bit more to meet their spending needs, we would then start saying to spend from their taxable accounts prior to their tax-advantaged accounts. And the whole goal here is really to minimize the amount of taxes that clients pay because what happens is every dollar that they pay to taxes is a dollar less that they have to spend.

Benz: So, they're using rebalancing proceeds or whatever other strategy they might be using just to extract that money from the taxable accounts?

Jaconetti: Absolutely. So, actually it's a good time at the rebalancing event [for investors] to possibly look at their taxable account to see if there are any asset classes that are overweight or underweight and spend from their taxable portfolio: Any asset that would be at a loss, any asset at no gain, and then finally spend from assets with gains. And then you could rebalance within the tax-advantaged account. Obviously, you don't want to violate the wash-sale rule, but that's a good way maybe once a year to rebalance a portfolio as well as generate the cash flow that you think you would need.

Benz: So, you've gone through the taxable account. And then, assuming that someone still has additional monies that they would like to extract from the portfolio, do we move over to the tax-sheltered accounts, and how do we sequence them?

Jaconetti: Yes. Within the tax-advantaged accounts, the decision really is to spend from your tax-deferred accounts--say, 401(k) or traditional IRA-type assets--when you think your tax rate will be the lowest.

For some investors they may have part-time income when they retire. So their tax rate today might be a little bit high relative to the future, so they would want to spend from their tax-free accounts today and then spend later from the tax-deferred accounts when their tax rate drops.

Conversely, say, a client has a majority of their assets in their IRA, and down the road they are looking at significant RMDs, RMDs that would maybe even push them into a higher tax bracket. It may be better for them to spend from their tax-deferred accounts today, locking in tax at the lower rate and then possibly reducing future RMDs so that the tax rate in the future would actually be lower, as well.

Benz: Colleen, a lot of moving parts here, a lot of different variables for retirees to contend with. Thank you so much for shedding light on this important issue.